Trouble from Cyprus deal could linger for eurozone

From front left, French Finance Minister Pierre Moscovici, Managing Director of the International Monetary Fund Christine Lagarde, German Finance Minister Wolfgang Schaeuble and Austria's Finance Minister Maria Fekter speak with each other during an emergency eurogroup meeting in Brussels on Sunday, March 24, 2013. The EU says a top official will chair a high-level meeting on Cyprus in a last-ditch effort to seal a deal before finance ministers decide whether the island nation gets a 10 billion euro bailout loan to save it from bankruptcy. (AP Photo/Geert Vanden Wijngaert)

FRANKFURT, Germany (AP) — European leaders may have saved Cyprus from imminent financial collapse when they clinched a last-minute deal in the early hours of Monday morning.

The way they did it, however, has left political and psychological scars across Europe that are far out of proportion to the island nation's tiny size — and that could hinder the eurozone's efforts to solve its debt crisis.

The deal was agreed with euro finance ministers along with the International Monetary Fund and the European Central Bank, hours ahead of a crucial deadline. The ECB was threatening to cut off crucial emergency assistance to Cyprus's struggling banks Monday if no agreement was reached. The resulting collapse would have dragged Cyprus's economy down and possibly pushed the country out of the euro.

As well as signing off on a 10 billion euros ($12.94 billion) rescue loan, the deal includes a far-reaching restructuring of the country's two largest banks, which were insolvent.

The rescue puts the costs of the country's broken banks where many analysts, finance officials and Europe's political leaders say they really belong: on the two big Cypriot banks' creditors, shareholders and big wealthy depositors — not on taxpayers and small savers. The country also agreed to restructure and downsize its banking system, which had ballooned to seven times the size of the economy, so it would not threaten the country's economy again. The eurozone average is about 3 ½ times the size of the economy.

Before Monday morning's agreement came 10 days of tortuous debate and delays. The initial deal agreed on Mar. 16 was overwhelmingly rejected by Cyprus' parliament. The country's banks then closed to prevent depositors from withdrawing all their money.

Here's a look at some of the problems raised by the latest eurozone rescue:

— SAFEGUARDING SAVERS: The Cyprus rescue undermined Europe's deposit insurance guarantees. Deposit accounts with less than 100,000 euros are protected by a European guarantee scheme if a bank collapses. But that didn't stop eurozone officials from proposing to take 6.75 percent of deposits from people with less than the insured limit.

The move was rejected but the mere mention raises the chance small depositors in other indebted countries will lose trust and flee in some future crisis, putting pressure on banks.

Economist Reinhard Cluse at UBS says eurozone leaders may have to come out soon with a strong statement stressing that the €100,000 limit will be secure in the future.

"They will hope that this sends a strong signal to depositors in other troubled eurozone countries (above all Greece, Spain) where depositors might react a lot more nervously in the future," Cluse wrote in a note to investors.

— NORTH-SOUTH DIVIDE: The dispute over how to rescue Cyprus underlines the eurozone's deep political fault line between the donor countries in northern Europe such as Germany, the Netherlands and Finland and the zone's indebted countries in southern Europe.

The immoveable limit on what donor countries would agree to loan, and the tough conditions for it, also underscore the hard line that Germany, the bloc's largest country and chief backer of any rescue, is taking. The debtor countries are often regarded in the German press and public discussion as seeking handouts to cover irresponsible behavior. The south returns the favor by grumbling over German domination. Enforced conditions include raising business taxes and shrinking the banking system that made Cyprus a prosperous offshore financial center.

"The German government played hardball, based on the assumption that the consequences of a Cypriot 'no' would be much graver for Cyprus than for the rest of the eurozone," wrote analyst Carsten Brzeski at ING.

FISCAL DISUNION: Some analysts say the German refusal to contribute serves as a reminder of how far the eurozone remains from any kind of common responsibility for state finances — such as sharing the future costs of winding up bailed-out banks.

Leaders from the 27-member European Union agreed last year to establish a joint banking supervision system, which would be followed by an authority with powers to warn or even shut down financial institutions, and a common way to restructure them. It's a key step to overcoming the crisis, aimed at keeping banks from dragging down governments.

One idea was to use the European Stability Mechanism bailout fund to give aid directly to ailing banks — avoiding adding more debt to the government. However, German resistance to the idea — and the structure of Cyprus's rescue, hitting creditors first — seems to have put that idea on the shelf.

—RETURN OF THE GREEK TRAGEDY: The rescue loan may leave so much added debt, and reduce economic growth so much, that some analysts are already saying another bailout may one day become necessary — as it did with Greece. UBS analysts say the deal will mean a "sharp drop" in economic output and a rise in debt from 86.5 to 143 percent of GDP. The official prediction of 100 percent of GDP by 2020 under the deal "must be doubted, in our view."

—DECISION-MAKING DELAYS. The deal painfully exposed the cumbersome decision-making among the 17 governments. Cyprus has been in obvious trouble since losing access to bond market borrowing in late 2011. Yet the rescue was only sealed, on the second try, after an all-night scramble hours ahead of the ECB deadline.

The last-minute decision making — especially the misfired proposal of the levy on small depositors — led to criticism even from EU officials.

"Citizens and markets are puzzled with the degree of improvisation that euro zone leaders have shown," said Sharon Bowles, chairwoman of the economic and monetary affairs committee of the European Parliament. "Shaky agreements that last less than 48 hours are very costly for everybody and lead to an explosive political situation."

"No system and no structure can afford to be in a permanent state of emergency."